Competitiveness and Private Sector Development

This series of publications addresses different aspects of private sector development in non-OECD regions, including the Middle East and North Africa, South East Europe and Eurasia. Reports provide recommendations at the national, regional and sector level to support countries in improving their investment climate, enhancing competitiveness and entrepreneurship, raising living standards and alleviating poverty.

With a total population of over 75 million people and a strategic location between wealthy trading partners, with Russia to the east and a vast market of EU citizens to the west, the Eastern Europe and South Caucasus (EESC) region is attractive as a destination for investment and trade. It is endowed with significant human and resources ranging from the black soil in Ukraine that produces some of the best wheat in the world, to energy reserves in Azerbaijan and unexplored water resources in several countries. However, in spite of recent growth – an average of almost 8% of GDP during 1998-2008 – the region’s productivity levels remain 77% below the world average. The OECD Eastern Europe and South Caucasus Competitiveness Outlook examines the key policies that would increase competitiveness in the countries of the region through developing human capital, improving access to finance for SMEs and creating more and better investment opportunities.

Eastern Europe and Southern Caucasus (EESC) is one of the fastest-growing regions in the world. The six countries in the region are Armenia, Azerbaijan, Belarus, Georgia, Republic of Moldova and Ukraine. Like its neighbours to the east in Central Asia, these countries have been faced with the challenge of transitioning from centrally planned to market-based economies. In order to improve growth and development perspectives, the governments of Eastern Europe and South Caucasus have already enacted several waves of far-reaching economic reforms and strengthened ties to the European Union and its single market. These policies were rewarded with double-digit growth from 2002-2008 and a boom in FDI inflows to the region.

This report is the outcome of work conducted by the OECD Eurasia Competitiveness Programme under the authority of the Eastern Europe and South Caucasus Initiative Steering Committee (referred to in this publication as the "OECD"), in close collaboration with governments and the private sector in six countries of the region. A number of ministries, government agencies, and private sector associations of the following countries contributed by their input to this report: Armenia, Azerbaijan, Belarus, Georgia, the Republic of Moldova and Ukraine. The collaboration was led by the national contact points in the six countries of the region: Mr. Garegin Melkonyan, Deputy Minister of Economy of Armenia, Mr. Shahin Mustafayev, Minister of Economy of Azerbaijan, Mr. Anton Kudasov, Deputy Minister of Economy of Belarus, Ms. Vera Kobalia, Minister of Economy and Sustainable Development of Georgia, Mr. Sergiu Ciobanu, Vice Minister of Economy of the Republic of Moldova, Mr. Andriy Klyuyev, First Deputy Prime Minister and Minister of Economic Development and Trade of Ukraine.

The Eastern Europe and Southern Caucasus (EESC) is one of the fastest-growing regions in the world. The six countries in the region are Armenia, Azerbaijan, Belarus, Georgia, the Republic of Moldova and Ukraine. Following the post-Soviet transition and particularly between 2002 and 2008 it reached double-digit growth – a rapid expansion that was driven by high capital inflows, rising domestic consumption and expansionary fiscal and monetary policies. However, this expansion came to an abrupt end in late 2008 with the onset of the global financial crisis. The EESC economies have now embarked on a recovery, although expansion in 2011-15 is likely to be weaker than in the preceding period. The World Bank 2010-13 forecast expects real GDP growth to be lower than in other developing countries: between 2.9% and 5.7%.

Supported by strategic location, natural resources and policy reforms, the economic performance of Eastern Europe and South Caucasus has been improving during the last ten years, reaching high GDP and productivity growth rates. Nevertheless, much remains to be done to unlock the full potential of the region. This chapter highlights the challenges that the region is facing, including low productivity, undiversified trade, reliance on external financing and a difficult business environment. Apart from this, three key areas supporting competitiveness – human capital development, access to finance for small and medium enterprises (SMEs) and investment policy – need to be further addressed. Measures should be taken to improve the quality of education and bridge the skills gap in the labour market by improving the quality of vocational and continuing education and training systems, to improve the access to finance for SMEs by addressing the issue of asymmetric information and better credit information, and promote investments by reducing restrictions to national treatment. The chapter notes that these challenges should be tackled through enhanced public-private dialogue, with the active participation of the private sector in the policy process.

The competitiveness of the countries of Eastern Europe and the South Caucasus (EESC) is analysed using the Global Competitiveness Index (GCI) of the World Economic Forum and the 12 pillars which determine the level of productivity of a country. Armenia, Azerbaijan, Georgia, Republic of Moldova and Ukraine are compared to both EU Accession 12 countries and transition countries. As a group, their major competitive advantage is labour market efficiency, while inefficient infrastructure and poor quality of education dominate as challenges. They also differ in their technological readiness, higher education and training, the quality of their infrastructure and the stability of their macroeconomic environment. Their business environment must be more supportive of entrepreneurship, new business, trade and foreign direct investment, as well as reducing the dominance of large firms in key markets. The reforms of their financial markets have taken a step backwards during the recession, with particular problems in access to finance for the business community and a need to stabilise the banking system.

Human capital is a vital element for the competitiveness of any country and amongst the most important areas of investment for economic and social development. The legacy of Soviet education has left the countries of Eastern Europe and the South Caucasus (EESC) with very good performance on education indicators such as enrolment and literacy rates, girls’ participation, progress to higher levels of education and pupil-teacher ratios. Yet on a number of other indicators, especially those related to spending, quality and relevance of education, the EESC countries fail to approach the international benchmarks, and thus to mobilise the full competitiveness potential of their people and economies. Despite, sometimes, considerable budgetary efforts, spending per student is low and is stagnating or declining in many countries. Judging by international surveys, the quality of school education in the EESC countries ranges from average, through significantly below average, to very low. Tertiary enrolment rates in Azerbaijan, Georgia and Republic of Moldova are below the level needed to compete effectively with OECD countries, and vocational education and training (VET) in all of the EESC countries is in urgent need of reform.

Access to finance is critical for small and medium-sized enterprises (SME), as it allows small enterprises to leverage their limited internal funds and provides additional resources to expand their turnover and their investment. However, due to the high administrative costs associated with small-scale lending, the high risk attributed to small enterprises, asymmetric information and the lack of collateral provided by SMEs, banks and financial institutions have lower incentives to provide credit to SMEs. In the Eastern Europe and South Caucasus region in particular, SMEs face constraints in the form of high real interest rates and collateral requirements as well as reduced possibilities of external financing outside the banking sector. This chapter discusses the challenges facing SMEs in accessing finance and the measure to be taken by policy makers. In the long run, the sustainability of a viable SME sector will depend on such factors as the creation of an efficient regulatory framework, and a sound and competitive financial sector. However, in the near term, a number of options are available to policy makers: A system based on multiple licences should be introduced to allow microfinancing institutions to gradually become self-sustainable. The quality of credit demand should be improved through financial education and entrepreneurial skills training. In the short term, SMEs can also be financially supported through credit guarantee schemes.

Foreign direct investment (FDI) flows are increasingly important as a source of finance for the economies of Eastern Europe and the South Caucasus (EESC). To unlock the region’s full potential, further reforms are needed to improve the investment environment following the proclamation of new investment laws in the 1990s. Key areas to address include better law enforcement mechanisms which include ensuring transparent and non-discriminatory legal proceedings. Policy makers in Eastern Europe and the South Caucasus also need to focus on diversifying the sectors receiving FDI and strengthen investment promotion and facilitation capabilities. Investment promotion activities should be more closely linked to investment policy reform and industrial policy objectives, as well as supporting regional development.

This chapter is a country case study. It looks at specific ways to enhance a country’s productivity levels through focusing on boosting the competitiveness of selected economic sectors. The chapter also looks at other elements likely to affect the general attractiveness of the business environment, such as a new Tax Code. Ukraine’s size, qualified labour force and natural endowments combined to make it one of the fastest growing economies in Europe between 2000 and 2008. Following its deeply-felt recession of 2009, Ukraine resumed positive growth in 2010. However, the recession exposed severe structural weaknesses in the economy, especially with regard to the underused potential of many of its economic sectors. Among the key challenges it must address to improve competitiveness and embed sustainable economic growth are: a low level of FDI per capita, an unfavourable business climate, high external debt, inadequate implementation of laws and the lack of a long-term strategy for investment policy and promotion. For optimum effectiveness of FDI it must be both diversified and its investment policies and promotion must be made sector-specific. Investment and promotion strategy and recommendations must focus on how to differentiate Ukraine and show its uniqueness for investment, how to identify sector-specific policy reforms, how to promote specific sectors, how to implement and monitor reform, how to evaluate progress and how to enhance its policy convergence with OECD investment instruments. The sectors identified for further study of their competitive advantage are Ukraine’s grain and dairy sectors, energy production based on biomass and the civil aviation manufacturing sector.